Germany: Summary of the new Draft Administrative Principles for the Attribution of Interest free Dotation Capital to Branches of International Banks for German Tax Purposes

Last Updated: 20 February 2004
Article by Hans-Jürgen Hennig

The new Administrative Principles replace the old provisions for the determination of bank branch dotation capital which expired on 31 December 2000. The new rules will take full effect from 1 January 2004 with mitigating transitional provisions not yet fully decided for years 2001-2003. The new provisions will result in a substantially higher bank branch dotation capital required for German tax purposes. This will increase the portion of disallowed interest and result in a substantial step-up of the taxable income of the German bank branch under the new rules.

I. Background and purpose of the intended Administrative Principles

The German Ministry of Finance released under the date of 20 January 2004 draft "Administrative Principles for the Attribution of Dotation Capital to Branches of international Banks" to Banking Industry Associations for comments.

The new Administrative Principles are designated to replace the old generally favourable German tax rules for the calculation of dotation capital, which were applicable for fiscal years ending after 31 December 1995 until 31 December 2000. Under these old rules, the required dotation capital amount for tax purposes was expressed as a percentage of the balance sheet total of the branch. The applicable percentage was at maximum 2% of the balance sheet total with certain capping provisions in the case of large branch operations. In the case of a balance sheet total of € 1.000m, 1% of the balance sheet total, i.e. € 10m was required as dotation capital under the old rules. In the case of a balance sheet total of € 5.000m, the required dotation capital was € 24m.

Once there was a missing dotation capital amount for German tax purposes due to the old rules, the additional amount required was notified in the annual tax returns to be filed. Generally, the missing dotation capital amount was multiplied with an appropriate funding interest rate. The interest amount so calculated was then added to the taxable income of the German branch.

Assuming a missing dotation capital for German tax purposes of € 20m and an applicable interest rate of 3%, the amount disallowed as interest payable on the head office account (or alternatively considered as additional branch income) would amount to € 0.6m.

These old rules were applicable to German branches of EU banks and certain non EU banks (US, Australia, Japan). For all other bank branches the statutory dotation capital according to the German Banking Act was also relevant for German tax purposes.

Under the new rules outlined in more detail below, the dotation capital amount now required for German tax purposes will be substantially increased, compared with the old tax rules. This should in most cases already apply for periods after 31 December 2000 due to the transitional provisions to be applied during the period after the expiry of the old provisions until 1 January 2004. The new rules will take full effect from 1 January 2004 onwards. The disallowed interest under the new rules will be subject to an aggregate German corporate income tax charge of about 40%.

While administrative principles are binding only on the tax authorities and have no legal effect for the taxpayer, they indicate which position the tax authorities are likely to take on the subject matter. The proposed Administrative Principles would apply to both German branches of foreign banks and foreign branches of German banks.

II. Procedure for the determination of the dotation capital

The draft is designed to implement Part II of the OECD Discussion Draft on the Attribution of Profits to PEs (permanent establishments) of Banks issued in March 2003. The draft Administrative Principles are not yet publicly available, but it is understood that they contain the following provisions:

1. Allocation of bank's risk-weighted assets and market risk positions to the branch
As a first step it has to be determined which of the bank's risk-weighted assets ("Risikoaktiva") and market risk positions ("Anrechnungsbeträge für Marktrisikopositionen") have to be allocated to the individual branch based on the functions actually performed by the branch (allocation step).

2. Valuation of the risk-weighted assets and market risk positions allocated to the branch
As a second step a valuation of the risk-weighted assets and market risk positions allocated to the branch is required by application of German regulatory rules or equivalent rules as applicable in the country of the head office (valuation step). Positions hedged intrabank and the head office / interbranch accounts receivable are to be eliminated.

3. Determination of dotation capital
After the above valuation made the draft suggests two basic methods to determine the dotation capital to be attributed to a branch by requiring a minimum amount:

(1) The first and primary method is similar to the BIS ratio approach suggested by the OECD and allocates the total bank's equity between the head office and its branches based on the proportion of the risk-weighted assets and market risk positions of the individual branch to the total risk-weighted assets and market risk positions of the bank as a whole (equity pro-rating method).

(2) The second method, which is generally only to be applied if the first method leads to economically unreasonable results, is similar to the quasi-thin capitalisation approach suggested by the OECD. It requires for the branch to have the same amount of dotation capital as would be required for regulatory purposes by an independent bank operating in the host country taking into account the risk-weighted assets and market risk positions allocated to the branch (arm's length approach).

(3) However, at least a certain minimum dotation capital needs to be attributed to the branch for tax purposes.

4. Calculation of the minimum dotation capital
The minimum dotation capital is generally calculated under the principles of allocation and valuation as outlined above. The minimum dotation capital then amounts to 8% (basic factor) of the sum of the valued risk-weighted assets and market risk provisions plus a supplement of 0.5%.

The basic factor of 8% can be reduced depending on the mixture of the core capital (tier 1) and additional capital (tier 2) amounts of the total bank. In any event, the minimum basic factor is 4%.

5. Further intended provisions and application date
The draft provides for simpler rules for small banking branches or new branches.

The new Administrative Principles for the Attribution of Dotation Capital to Branch Banks are to be applied from 1 January 2004.

6. Transitional provisions for the period after 31 December 2000 to 1 January 2004
The old provisions for the determination of bank branch dotation capital (as included in the Administrative Principles of 24 December 1999 for the Determination of Profits to be allocated to a PE) expired on 31 December 2000. There are transitional provisions to be applied during the period after the expiry of the old provisions until 1 January 2004. These transitional provisions generally require the bank branch to have the above minimum dotation capital.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.

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